Credit Where Credit is Due

Very few places on the planet enjoy a healthy consumer credit environment, an environment in which people are given the opportunity to prove they can manage debt. Where it exists, magic happens. People in those places become an important part of the economic engine that drives a country forward.

The US enjoys a particularly healthy credit environment. People there can earn credit and take it from one institution to another. They can, for example, take out a loan from one bank, pay it back, and then use the resulting positive reputation to take out a bigger loan from another bank. There aren’t many places in the world where this is possible.

In countries in which consumer credit is otherwise healthy, credit is often tied to a lender. In France, for example, I can build up credit at one bank, but that will mean nothing if I change banks. This is OK, but far from ideal.

Both the US and France are rich countries with well-developed financial systems. But what about places in which few people even participate in the financial system? In Argentina, for example, 80% of people don’t. If they have a bank account, they don’t keep money in it, and they don’t have credit cards or bank loans.

This lack of consumer credit, which affects most people on the planet, is harmful to both individuals and the countries they live in.

I won’t go into how we got here. It’s a long, complicated story. Instead I’d like to focus on what people are doing about it.

Most governments are doing nothing to fix this problem. This will surprise no one!

Traditional lenders, banks primarily, are also doing very little. This isn’t because they wouldn’t love to solve the problem — most bank revenues are derived from loans! — but because of economic and political barriers such as:

poverty,

corruption,

poor education, or even

lack of government support.

It turns out that bootstrapping a credit system is very difficult! This leaves the door open to scrappy innovators.

Before I talk about these innovators, I need to make one other thing clear:

You can’t lend people money without (1) having a way to make sure you’ll get the money back, (2) having a reasonably good idea that the borrower is likely to repay the debt , or (3) both.

To make sure we get our money back, we need some kind of Enforcement. Physical enforcement is the primary mechanism behind criminal credit. In Italy, for example, someone who might not be able to get a loan from a bank, could easily get one from the local mafia. If the loan isn’t repaid as agreed, the mafia might enforce the “contract” by physically harming the borrower. This is effective, but also rather unsavory. Thankfully, we’ve developed a less gruesome enforcement mechanism. If someone fails to repay their debt, we harm their credit score instead of their person. In a well-functioning financial system, a person’s credit score will affect their future ability to borrow, so keeping it healthy is important!

But what about the second component: being able to predict whether or not someone is likely to repay a debt? It turns out that a person’s credit score is derived from data about their past behavior, so it should help us predict future behavior.

A credit score is therefore a key component of our enforcement mechanism and our prediction mechanism. Very clever!

This score works really, really well in a traditional financial system because all incentives are aligned behind it. But what about outside that context? In that messy world, we need other ways to predict a borrower’s behavior.

This is where innovative companies like Utu come in. They use social media, gaming, and transport data to determine whether or not someone might be a good credit risk. Utu use this data to produce credit scores that allow lenders to make smart decisions. This is difficult work! Collecting the data is difficult. Predicting people’s behavior from that data is even more difficult. But the more lenders use the data and provide feedback about the outcome of loans, the better the predictions become. It won’t be long before your social profile will be a better predictor of your creditworthiness than credit history.

This is an astonishing development. Twenty years ago, no one would have predicted that this was even remotely possible. These alternative credit scores will change the economic environment in countries where most unbanked people live today.

Careful readers will have noticed that these alternative credit scores are not exactly like their traditional counterpart. They cannot be affected by failure to repay a loan since that data is not used to compute the score. That data is not used because transactions between lenders and borrowers are private, and therefore invisible. An alternative credit score, unlike its traditional counterpart, cannot be part of an enforcement mechanism, with one exception.

If loans are managed on public blockchains, transactions are public, so they can be taken into account when computing alternative credit scores. Is that happening? It is.

Cryptocurrencies are fast becoming the foundation of a new financial system, especially in places without a strong existing infrastructure.

This new financial system has properties that don’t exist in its traditional counterpart. In other words, we aren’t witnessing the emergence of a “more efficient” system, we’re witnessing the emergence of a different system. Anonymity and the ability to transact peer-to-peer change the dynamics completely. In the credit space, these different dynamics are clear. We therefore need different ways of predicting and enforcing good behavior.

Companies like Utu are a big part of this story since they provide alternative behavioral data. But we need more than that in the crypto space. We need companies that approach the credit data problem differently than traditional credit bureaus. These companies need to consider anonymity, pseudonymity, and the global, trans-national, nature of blockchains.

Graychain is doing just that. We are producing credit scores for blockchain addresses, not people, and we are working with data providers like Utu to understand the behavior of people behind these addresses. Our work is providing the foundation for a new generation of lenders, lenders that will be critical to this new financial system.